Equity Valuation and Portfolio Management

OVERVIEW OF VALUE-BASED METRICS

We now provide an overview of VBM. Value-based metrics are financial measures that largely evolve out of corporate finance. The focus here is on metrics that can assist managers and investors in discerning whether a company is pointing in the direction of wealth creation or, unfortunately, wealth destruction. In the VBM approach to fundamental analysis, the focus is on discovering firms that can consistently earn a return on capital (ROC) that exceeds the weighted average cost of capital (WACC).

A financial metric takes on a VBM character when there is an explicit recognition of and accounting for the overall cost of capital (WACC in the economic value added model described below) or the cost of equity (r in the residual income or abnormal earnings model also described below). Hence, the most distinctive feature of VBM analysis (in contrast to traditional analysis) is the formal recognition of the investor's required rate of return (cost of equity) and the overall cost of capital. Value-based metrics include:

• Residual income (abnormal earnings)
• Residual income spread
• Economic value added (EVA^®)
• Economic value added spread
• Market value added (MVA)
• Cash flow return on investment (CFROI^®)

Background

We'll begin the VBM approach to equity analysis with a metric called economic value added (EVA). EVA was developed commercially in the early 1980s by Joel Stern and G. Bennett Stewart III. This economic profit measure gained early acceptance in the corporate ...